In a market environment that is highly volatile, any unfavorable economic, market or pandemic related news can move the financial indexes decidedly negative. During these times, holding on to cash may bring you the peace of mind needed to sleep at night. But, what if the very thing that brings you comfort today, may actually generate stress in the future?
The role of cash as an investment asset class
An asset class refers to a group of assets that display similar underlying economic characteristics. Investors look to various asset classes to diversify their portfolios, based on the fundamental qualities of each asset class. For example, equity is an asset class that is typically held in a portfolio for growth and capital appreciation, while fixed income is an asset class used to provide streams of income, such as periodic coupon payments from bonds.
Cash is an asset class held in a portfolio to provide liquidity, since it can be easily accessed at any time. There is a love/hate relationship when it comes to cash in an investment portfolio. In a recovering/growth market, cash is shun, as it can contribute to a drag on the performance of the portfolio. On the other hand, during times of market downturns/recessions, cash is embraced, as it helps control investment losses.
Asset classes and a diversified portfolio
A properly diversified portfolio should have some exposure to all or most asset classes (equities, fixed income, cash and alternative investments). The asset allocation mix will vary based on numerous factors, inclusive of your:
Investment objectives (risk tolerance and required returns);
Time horizon to invest;
Liquidity needs; and
Other unique circumstances.
If your liquidity needs are high, cash and fixed income will most likely dominate your investment portfolio. On the other hand, if your liquidity needs are low, and you have a long investment time horizon before you need to access your assets, your equity allocation may dominate your portfolio.
The riskiness of cash
Inflation hurts the purchasing power of cash over time. As prices of goods and services increase, cash loses value - $1 buys less goods and services it used to buy due to rising prices. If you’re holding more cash than needed in an inflationary environment, you may be unknowingly reducing your portfolio's value. If your portfolio does not grow by more than the inflation rate, your portfolio will buy less goods and services tomorrow than what you can afford today. A way to combat inflationary pressures is to invest your cash in inflation hedged assets - assets that outperform in a market when inflationary pressures are high.
Is there an optimal cash level?
So just how much cash should you be holding? You typically wouldn’t have a portfolio that is 100% invested in riskier assets, nor will you have a portfolio that is 100% invested in cash. When thinking about your allocation to cash, you want to ensure that you have sufficient liquidity to cover emergencies (in the event you fall upon hard times) or short-term planned expenditures. Keeping at least 3 to 6 months worth of expenses in cash, held in a high yield savings account or an equivalent savings product, is a great first step when deciding upon a foundational cash allocation.
Not sure about your cash allocation? Email us at Wealth@finwellbenefits.com or click below to schedule a free consultation to learn more about our investment philosophy and the investment options available to you.
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